S&P on the Kill List: U.S. Government Seeking Vengeance for S&P Downgrade of U.S. Credit.

S&P On the Kill List By Douglas French Thanks to Douglas French and The Daily Reckoning

“Paybacks are a bitch,” as they say.What was Standard & Poor’s thinking back in August 2011, when the ratings agency took the Red, White, and Blue’s AAA rating away? A rating the most powerful government in the history of the world had held for 70 years. S&P downgraded long-term US debt to AA-plus. That score ranks lower than over a dozen governments, including Liechtenstein’s, and is level with Guernsey’s and France’s.McGraw-Hill Companies (S&P’s owner) may be a big corporation, but you don’t kick sand in Uncle Sam’s face like that and get away with it. Now the government, in the person of Attorney General Eric Holder, is kicking back. The US government is accusing the ratings agency of committing fraud by inflating the ratings of mortgage investments, which, of course, created the financial crisis.S&P, along with its competitors Fitch and Moody’s, famously rated the mortgage security goulash that Wall Street concocted AAA, thus allowing everyone everywhere to participate in America’s housing boom. And why not? According to computer models, housing prices never go down. Pension funds as far away as Reykjavik and Heerlan were gobbling up what Wall Street was serving because all three ratings agencies provided their stamp of approval. According to the government’s suit, S&P “knowingly and with the intent to defraud, devised, participated in, and executed a scheme to defraud investors.” Yep, in the minds of the government’s gumshoes, the clairvoyants at S&P knew these securities stunk to high heaven. They knew, or should have known, that the housing market was ready to crash any moment, but they were greedy capitalists who, while they were making a buck, created and carried out a diabolical plan to bring the financial world to its knees. Yeah sure, that’s what happened. S&P should be ashamed for maintaining that it ratings “were objective, independent, uninfluenced by any conflicts of interest,” the suit said. The suit centers around 40 collateralized debt obligations (CDOs) created from 2004-2007. The firm was paid $13 million for rating these securities. Giving these securities the highest rating must have been fraud, because everyone knew by that time that the market was toast. Right? After all, in 2004, the nation’s deposit insurer and bank regulator, the Federal Deposit Insurance Corporation (FDIC), published a paper on housing that concluded: “It is unlikely that home prices are poised to plunge nationwide, even when mortgage rates rise.” This is because “housing markets by nature are local, and significant price declines historically have been observed only in markets experiencing serious economic distress.” Plus, housing markets have “characteristics not inherent in other assets that temper speculative tendencies and generally mitigate against price collapse.” In conclusion, “it is highly unlikely that home prices would decline simultaneously and uniformly in different cities as a result of some shift, such as a rise in interest rates.” Whoops. Where’s the lawsuit against the FDIC?

Pension Funds Learn to Say, “Sell!”

By Eric J. Fry

Pension plans are selling stocks. Headline or footnote?

Recent history suggests this little news item should be a headline. Pension plans – like supertankers, but unlike politicians – take a lot of time to reverse direction. But once plan fiduciaries decide to proceed in a given direction – investment-wise – they typically continue down that path for years, if not decades.

This tendency provides the mother of all long-term indicators for the financial markets. Although pension plan fiduciaries tend to be VERY wrong at major, long-term turning points, they tend to be right – more or less – as markets transition from one extreme to the other.

Confused?

The principal is actually very simple: pension plans behave like long-term momentum investors. So they tend to buy into rising markets…until after those markets have peaked and begun a major decline. Conversely, fiduciaries tend to sell into falling markets until after those markets have bottomed out and begun a decisive uptrend.

In aggregate, therefore, pension fund fiduciaries tend to behave like novice investors – buying high and selling low. But since their momentum investing unfolds over such long timeframes, this group of investors tends to be very right during the middle of a big move – up or down – in any particular asset class.

The world’s fourth largest pension provides a classic case in point. The California Public Employees’ System (CalPERS) with $181 billion of assets at last count, ranks fourth on the list of the world’s largest pensions plans. But it might rank first on the list of worst market-timers. Between 1983 and 2000 the pension giant doubled its allocation to equities…just in time for one of the stock market’s worst decades ever.

During the middle of this giant bull market, CalPERS was correct to up its allocation to stocks. But by continuously upping its exposure to a rising stock market, CalPERS eventually overdid it.

In September of 2000, as the U.S. stock market was beginning its colossal collapse from the then-record highs set earlier that year, your editor highlighted the vulnerability of CalPERS’ stock-heavy portfolio. In an article entitled “Golden State Bulls,” he observed, “In 1983, with a moribund Dow Jones Industrial Average hovering around 1,200, the powers that be [at CalPERS] deemed 30% to be the optimal equity weighting for the fund. But 17 years and 10,000 Dow point later, the CalPERs…investment committee now allocates a whopping 67% of assets to equity investments.

“Meanwhile,” the article continued, “the fixed-income allocation has atrophied to but a shadow of its former self: from 67% back in 1983 to little more than 28% [today]…That’s been a swell situation for the last few years. CalPERs – ominously referred to as the ‘The System’ in the fund’s literature – earned a 10.5% return on its investments for the year ending June 30, 2000, marking the sixth straight year of double-digit returns.”

Despite these pleasing investment results from the recent past, your editor wondered aloud about the immediate future: “If the bull market of a lifetime commenced when CalPERS was wading only ankle- deep in equities (some 30%), what does it mean that the pension giant now fairly bathes in them?”

Investors did not have to wait long for the answer: The stock market stunk up the place for the next nine years. Your editor highlighted this exact risk in his article.

“A back-of-the-envelope calculation shows that if the equity component [of the CalPERS portfolio] were to merely break even [during the next six years],” he warned, “the balance of the portfolio would need to generate a 25% return to meet the [fund’s] actuarial assumption. And you know, that may not happen every year.”

CalPERS did not welcome your editor’s pro bono investment advice. In an October 8, 2000, story in the Sacramento Bee, CalPERS spokeswoman, Patricia Macht, countered, “That’s (the magazine’s) back-of-the-envelope calculation. We don’t manage people’s money on back-of-the-envelope calculations…We’re not in stocks because we make a lot of money, we’re in at the level that’s prudent to be.”

Your editor, defending his criticism in that same Sacramento Bee story, replied, “Just because [CalPERS’ equity-heavy allocation] has worked doesn’t mean that it’s responsible.”

CalPERS would have none of this criticism…and neither would any of the giant pension’s many defenders and apologists. An influential money manager, who’s name your editor will mercifully withhold, ended the Sacramento Bee by scorning your editor’s concerns as “dead wrong.”

As it turns out, of course, your editor’s concerns were “dead right.” (The S&P 500 Index has produced a total return of minus 12% from the end of September 2000 to the present). But anybody can get lucky once or twice.

More to the point, CalPERS “knew better”…or it should have. It should have known that stocks sometimes go down. So it should have also known that a fund that must dispense billions of dollars every year to retirees cannot prudently allocate 70% of its portfolio to such a volatile asset class. But the investment mavens at CalPERS could not bring themselves to worry about worst-case scenarios while best-case scenarios were delivering such delightful returns.

And besides, the stewards of the giant pension fund certainly understood that – come what may – they could always cite chapter and verse of the long-term bull case for equities. They could simply remind their would-be critics that equities had outperformed bonds by a large margin over almost any timeframe during the preceding 100 years. Between 1900 and 1999, for example, U.S. stocks gained an average of 12.9 percent a year, while bonds returned only 4.7 percent annually, according to the data from the London Business School and Credit Suisse. Armed with such rear-looking data, and lots of pretty charts, the CalPERS pension fund charged into the new century loaded for bull.

This equity-heavy allocation seemed unassailably prudent to the stewards of CalPERS, who rarely missed an opportunity to congratulate themselves for a job well done. Not content to merely draw a paycheck, without also drawing attention to himself, Michael Flaherman, then-chairman of the CalPERs investment committee, crowed in mid-2000, “Our performance is the culmination of superior investment and risk management.”

No sooner had Flaherman slapped himself high-fives than the stock market Fates began conspiring to punish his unabashed hubris. Since the end of the last millennium, stocks have produced an average annualized loss of 2.3 percent, compared to an annual gain of about 6.3 percent for bonds. Not surprisingly, therefore, CalPERS’ equity- heavy fund has generated a meager 2.2% average annualized (gross) return since 1999. (For some mysterious reason, CalPERS discontinued reporting its investment returns net-of-fees in 2002. All of which means that the stated return of 2.2% would actually be a much smaller number).

But now that the bear market pony has frolicking outside the barn for several years, the CalPERS investment team is slamming the barn door shut. The team is drastically reducing its allocation to equities. As of last June, CalPERS reduced its equity target from 56% to 49% – the lowest such allocation since 1993. (Including “alternative” equity assets like hedge funds, the revised equity target would be 61.4%, down from 66%).

Net-net, CalPERS is now a seller of equities…or at least not a buyer. Most of the other pension plans in the U.S. (and in the rest of the world) will likely follow CalPERS’ lead.

“Equity assets in the U.K. fell to 41 percent of holdings at the end of 2008, according to data compiled by New York-based Citigroup,” Bloomberg News reports. “The last time British pension funds held so little in equities was in 1974…”

Meanwhile, Bloomberg continues, “Four of the world’s seven largest pension funds…have cut their equity target allocations…” It’s probably safe to assume, therefore, that “caution” is the new buzzword in the halls of most pension fund managers. So it seems highly unlikely that they will exhibit their former exuberance for equities any time soon.

Demographic trends, as well as caution, will prohibit aggressive equity allocations. In California, for example, the baby boomer retirement wave is just beginning, which means that CalPERS must begin favoring capital preservation over “long-term growth.” Ditto most other pension funds on the planet.

“The number of people worldwide 65 and older may jump to 1.3 billion by 2040 from 506 million last year,” Bloomberg reports. “Their proportion of the total population will double to 14 percent in the same period, according to a June report from the U.S. Census Bureau.”

“[Since] the heavy equity weightings of public pension funds in this great land of ours comprise not only the mother of all sentiment indicators, but also a monstrous overhang of stocks, what if the funds sell?” your editor wondered in his mid-2000 article. “No sane fiduciary would choose to sell stocks of course – not if he or she wished to retain a comfortably feathered nest. But demographic trend may force the hand…Probably, the looming overhang is nothing to worry about – right now. But when the overhang threatens to break loose, remember: you heard it hear first.”

That moment may have arrived.

An Updated Take on the Economic Situation

IMF Bombshell

Neville Bennett

There is a disconnect between the real world and Wall Street. Wall Street prices surge while real economy difficulties increase daily. Exports are falling, house prices are declining, and no-one can sell cars. However, There is a perception of “green shoots” indicate that that the real economy may recover quite soon because the financial sector has recovered, and a bull market is underway.

The financial sector, however, has been singled out by the IMF for a thorough review. It emphasizes the key challenge of breaking the downward spiral between the financial system and the economy. The IMF believes that “promising efforts” are under way to redesign the global financial system to provide a more resilient platform for sustained economic growth.

OVERVIEW

The financial sector needs mending. Banks and corporates need refunding, balance sheets have to be bolstered, and capital needs to flow across borders, especially to the merging countries. There is on-going destruction or corruption of assets, and the latest IMF estimate of write-downs has increased from US$ 2.2 trillion in January, to a possible US$4 trillion in April. The increase arises partly because of worsening picture of economic growth and the spread to other mature market-originated assets. About a third of newly-emerging write-downs will be incurred by non-banking institutions

There have been some improvement in interbank markets but funding remains a difficult issue, especially long-term funding. In some jurisdictions banks can issue government guaranteed, longer term debt. But the funding debt is big, with the result that many corporations are unable to obtain bank-supplied longer term debt or even working capital.

Present Risks

The crisis has deleveraged asset prices causing much distress. Some Pension funds and Life Insurers are now underfunded. Some managed their risks prudently, but others undertook risks which they did not really understand. The greatest problem is, however, the decline of cross-border funding. Emerging market economies desperately need refinancing, probably to the tune of $1.8 trillion in 2009. They had relied on private capital flows but these have been reversed.

Although there have been massive fiscal stimulus packages already, further policy action is necessary to restore confidence and thereby relieve uncertainty. Uncertainties are “undermining the prospects for an economic recovery”. The cost of these packages is causing concern, especially when the debt burden combines with longer-term pressures from an aging population. There is a “home-bias” as officials encourage banks to lend locally and consumers to keep their spending domestically orientated.

These are extremely challenging times as officials try to break a downward spiral which is dragging down the financial sector and the real economy.

Recommendations

The economic recovery will be protracted. The deleveraging process is not over and will continue to be slow and painful. Credit growth will contract in the US, UK, and EU, and only recover after a number of years. But political support for more fiscal and monetary aid by the state is waning. There is a risk that governments will be reluctant to allocate sufficient funds to solve the problem.

Restoring the banking system will take several years. Governments should co-ordinate policies to ensure that the banking system has access to liquidity; the impaired assets are identified and dealt with; and weak banks and other viable institutions should be recapitalized. Lessons from previous crises suggest that very forceful measures are required to resolve financial sector weakness.

The IMF has tried to assess existing losses and possible future write-downs in Western banking systems in 2009-2010. Its lowest estimate is $275 bn for US banks, $375 for Euro and $125 for British banks, and about $100 bn for other European banks. But the banks must first increase certainty identifying their capital needs and disclosing impaired assets. Bank supervisors must be very strict in evaluating bank claims and business plans. Viable with insufficient capital could get sufficient capital injections from the state to encourage private capital to join in raising capital ratios.

While banks use public money, their operations must be closely monitored, dividends and restricted, and compensation closely examined. There will be cases to replace top management. Non-viable banks could be merged with others or undergo orderly closure.

The difficulty in attracting private capital means deep government involvement is necessary, even to the extent of taking control. But ideally, the bank will be returned to the private sector as quickly as possible. It would be helpful to convert Government holdings of preferred shares to common stock.

Funding Needs

Bank funding remains highly stressed. Some governments have guaranteed deposits and some forms of bank debt, but wholesale funding is inadequate. Central banks will continue to need to provide ample liquidity for the foreseeable future.

Emerging markets are hemorrhaging capital and this will continue over the “next few years”. Their central banks will also need to provide ample liquidity, and also perhaps foreign currency through swaps or outright sales. IMF’s enhanced resources can buffer the financial crisis. The larger problem in emerging markets is a lack of capital to roll over corporate debt. Government support seems warranted to keep trade flowing and limiting damage to the real economy. The situation warrants devising contingency plans to prepare for large-scale restructurings in case circumstances deteriorate further.

Pressure to support domestic lending may lead to financial protectionism. In several countries authorities have stated that banks receiving support should expand their domestic lending. This could crowd-out foreign lending as banks face on-going pressure to delever balance sheets, sell foreign operations and remove risky overseas assets. These policies can damage the global economy.

Fiscal issues

Credit growth is necessary to sustain economic activity. In countries with fiscal room for maneuver, fiscal stimulus will be welcomed by markets. But markets are showing concern in countries where debt is an issue, and bond yields have increased and currencies weakened.

There is a universal need for stimulus now, but this clashes often with issues of sustainability. Governments risk a loss of confidence in their solvency if there are no plans for debt reduction

Conclusion

Policymakers have to address urgently the present crisis as well as devising a more robust financial system. Improved financial regulation and supervision are key components in preventing future crises by mitigating future systemic risk. The financial system will remain under pressure for years and require massive new funds.